Factbox: What tools does the Fed have to boost growth?
(Reuters) - A much weaker-than-expected U.S. labor market and escalating financial turmoil in Europe have raised the chances the Federal Reserve will intervene to protect the fragile U.S. recovery.
Top officials at the central bank had said the economy was unlikely to need more monetary support as long as there was progress in reducing painfully high unemployment.
But a report on Friday that showed U.S. employers added only 69,000 workers to their payrolls last month put the Fed back in play as a potential source of stimulus.
The central bank has held overnight interest rates near zero since December 2008 and has bought $2.3 trillion in U.S. government and mortgage debt to further lower borrowing costs.
Its policy panel holds its next meeting on June 19-20.
Following is a menu of options for Fed action:
EXTEND RATE PLEDGE -
The Fed has said it expects economic conditions to warrant keeping rates "exceptionally low" at least through late 2014. It could push that date further into the future.
Before the jobs report, rate futures were pricing in the first rate hike by the end of 2014. On Friday, they shifted that date out to April 2015.
Pros: This would be the easiest step to take. Pushing the date of the first likely rate hike into 2015 could help lock in current expectations or move them out further.
Con: The farther into the future the Fed pushes the date, the less believable it is. As it is, it is unclear whether Ben Bernanke will still be Fed chairman in late 2014.
Chances: RBC Capital Markets analyst Michael Cloherty gives extending the late-2014 language a 20 percent chance.
EXTEND OPERATION TWIST -
The Fed could extend "Operation Twist," its program of selling short-term Treasuries and replacing them with longer-dated U.S. government debt. The program is due to expire at the end of June.
Under Twist, the Fed exchanged about $400 billion worth of securities maturing in three years or less for debt of six to 30 years in duration. Macroeconomic Advisers economist and former Fed Governor Laurence Meyer estimates the Fed has roughly $160 billion worth of short-term securities remaining.
To extend the program, it could sell securities with a somewhat longer maturity. If it moved to sell securities with maturities up to four years, it would be able to exchange roughly $375 billion, Meyer estimates.
Pro: Although many analysts don't think this would provide much bang for the buck, it would signal the Fed is still in easing mode.
Cons: Long-term interest rates are at record lows, so it is unclear how effective driving them lower would be. Also, the Fed's ownership of securities with maturities of 10 years or longer would rise from 30 percent to 40 percent, a level that could create market distortions. Finally, sale of intermediate-term securities might put upward pressure on rates for automobile and other consumer lending.
Changes: RBC's Cloherty gives extending Twist a 10 percent probability.
TWIST ON TWIST - The Fed could add mortgage-backed securities to its Twist purchases.
Pros: Doing so would let the Fed buy a larger amount of securities and would have the side benefit of helping the housing sector, a weak link in the U.S. economic recovery so far.
Cons: Earlier heavy MBS purchases disrupted markets.
Chances: Cloherty rates this option as a 60 percent chance.
MORE QUANTITATIVE EASING -
The Fed could decide to expand its $2.83 trillion balance sheet further with more outright purchases of Treasury or mortgage bonds, or perhaps a mix of both.
Pros: This would be a powerful rejoinder to a weakening economic outlook and would lift inflation expectations.
Cons: More bond buying would draw political criticism and could revive fears that the Fed has set the stage for inflation.
Chances: Cloherty sees virtually no chance of outright Treasuries purchases. However, Morgan Stanley analyst and former top Fed staffer Vincent Reinhart sees an 80 percent chance of some form of Fed balance-sheet action, whether outright bond buys or a Twist operation. Macroeconomic Advisers' Meyer also believes outright bond purchases, probably including MBS, is the most likely scenario.
STERILIZED ASSET BUYING -
The Fed could buy more bonds but drain excess bank reserves with reverse repurchases and term deposits.
Pros: This could achieve the Fed's goal of pushing down longer-term interest rates, but address worries about inflation and political blowback.
Cons: Sterilized purchases would still expand the Fed's balance sheet, which could excite inflation concerns despite draining reserves.
Chances: Cloherty sees only a 2 percent chance for this tactic. Reinhart sees some sort of hybrid between Twist and a sterilized operation as the most effective option.
MONETARY POLICY FRAMEWORK -
The Fed is already working on changes to its monetary policy framework that would give investors a better idea of how long the central bank might wait until raising rates. For example, it might describe different scenarios, perhaps by using certain threshold levels of inflation and unemployment, and explain how policy would respond.
Pro: If these changes convinced markets the Fed would be on hold longer than currently thought, it could provide some stimulus.
Cons: It might take awhile to come up with something on which all Fed officials can agree and might not offer a message that would ease financial conditions.
SOMETHING TO HELP EUROPE -
The Fed could take some action aimed at easing financial strains in Europe, which are seen as undercutting the U.S. recovery.
It already has a currency swap line with the European Central Bank to ensure dollar liquidity for banks in the region. It could cut the rate it charges on the swaps and expand the facility.
Pro: It could send a supportive signal during a time of financial stress.
Con: The Fed would likely face harsh political criticism for action some see as beyond its responsibilities.
Chances: Cloherty sees an 8 percent chance.
(Reporting by Mark Felsenthal; Editing by Jan Paschal)
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